Rebalancing and Indexes

This rebalancing issue may explain why most active managers underperform: According to Hendrik Bessembinder, a finance professor at Arizona State University, the entire gain in the U.S. stock market since 1926 is attributable to the best-performing 4 percent of listed companies, and the cap-weighted indexes captured all of it because they don’t rebalance.



Link to Article

Synthetic VXX 2006 to Present

Synthetic VXX prior to 2010

VXX hit a low in early 2007 at a synthetic price of 25k.  During the 2009 low it went to a synthetic high of 162.5k.  This was nearly 550% above the all time low and took nearly 4 years to recover.

https://flare9xblog.com/2017/12/02/vix-term-structure/

Assuming a short VXX position held through that bear market the following would not have led to a margin call.  

Turkey Contagion

It's unlikely that Turkey's debt crisis will have a meaningful effect on global markets.  The IMF will likely step in and bail out the nation.  Other central banks will make sure there is plenty of liquidity to prevent contagion as well.  Most of the time that liquidity finds its way into stock markets.

Wage inflation spiked on the previous NFP.  Data from the recent NFP shows wages growing at 2.7% yoy.  The past 3 recession were preceded by annual wage growth of more than 4%.

U.S. Tariff Policy and potential Trade War

The Trade War that President Trump's Administration is implementing has put a lid on equity market performance since February.  However, as we approach midterm elections, it looks less likely that the current U.S. Administration will be able to follow through with their tariff policy by September's deadline. 

Given the investigations around Trump and likelihood of a negative impact from the Mueller investigation, it's likely there will be elevated volatility and risk in the market. 

However, if Republicans maintain control of both the House and Senate and nothing significant comes from the Mueller investigation, it is likely that a trade war will offset any earnings growth potential discounted by the market.

More than likely, a negative impact from the investigation leading to volatility will occur and the trade war rhetoric will die down.  This will likely cause 1.5 - 2 months of volatility eventually leading to a rebound in sentiment and new highs in the S&P to close out the year.

Wage Growth Vs Inflation

Historically, it takes average hourly earnings of production and nonsupervisory workers growing at about 3% year over year to get inflation to the Fed’s 2% target. Wages rose 2.8% year over year in May, a modest and welcome upside surprise from expectations of 2.7% and still ahead of inflation, but not yet at that 3% threshold. Nevertheless, this was still the fastest pace of wage growth since June 2009, when wages were still early in their post-recession decline (they would bottom in October 2012 at 1.2%). It’s also the fourth consecutive month of year-over-year wage growth accelerating, a streak we haven’t seen since 2013. Given the Fed’s emphasis that its inflation target is symmetrical, indicating comfort with letting inflation run a little hot, we would not consider wages an immediate threat.

VXX Short Strategy

I made a spreadsheet where I plot daily VXX returns assuming a 25% core short position.  Then you push more shares into the core for every 20% drop in VXX.  The blue line is the return from initial principle.  The orange line is the maintenance equity for holding that short position.  From the model, it looks like if VXX were to rise about 180% from the avg price entry you would get a margin call assuming a 25% required maintenance margin.  

Stock Buyback Blackout Months.

January, April, July and October have lower repurchase rates because for the 1 month before an EPS report companies are not allowed to repurchase their stock.  This reduced demand can potentially exacerbate volatility in those stocks.

Adjusted Percent Return of BRK.B vs SPY

I read an article a few weeks ago stating that SPY has been outperforming BRK.B over the last 8 years.  Recently my friend asked me to check up on this so I looked into the data and it shows the opposite. 

BRK.B and SPY are both in the large cap space.  BRK.B is less diversified so it should have some outperformance, however it is also so large that it is also unlikely to consistently generate the return it has since the 1960s.

Here is a chart comparing the adjusted percentage return of BRK.B to SPY.  Since 2001, BRK.B has significantly outperformed SPY at a 330% gain compared to 190% gain.  Since 2010, however, the returns have been almost similar 194% vs 176% with BRK.B still outperforming.  Given that dividends would be taxed on the SPY re-investment, there is probably additional out-performance in owning BRK.B over SPY. 

The Best Suboptimal Strategy

being able to execute your plan or strategy is more important than find a perfect strategy because most of the time people are terrible at following their plan.  

“a suboptimal strategy that you can execute is better than an optimal strategy you can’t execute.”

A decent sub optimal strategy is to just own the market over any 7 year period.  The dividend adjusted nominal SP500 return has been positive over basically every 7 year period

http://www.simplestockinvesting.com/SP500-historical-real-total-returns.htm

However, inflation adjusted returns have a few 7 year periods that under performed.  The main question to consider in your sub optimal portfolio is how cheap or expensive the market is compared to 5 year T-notes. About 90% of the time markets will outperform the notes.  If you're young put every dollar that you don't need into the SP500 unless the market is in the upper 2nd standard deviation of DCF using Sp500 expected earnings compared to 5 year T-notes.  

Visa suspension program at Turkish consulate causing markets to go bidless.  Turkey central bank is trying to intervene, but they do not have the cash.  Will likely see continued declines in the Lira.  Expecting new highs in USD/TRY

Rate hikes and how they've affected market historically:

Four phases of monetary policy

In a recent report by Bank Credit Analyst (BCA) Research they highlighted the four phases of a monetary policy cycle based on the interaction between the level of rates and their direction. Policy is deemed to be easy if the fed funds rate is below its equilibrium level (Phases I and IV), and tight if it's above that level (Phases II and III). You can see the four phases, and the accompanying stock market performance, in the table below.

Source: BCA Research Inc. *Table excludes Phase III (July '95 to September '98) and Phase IV (April '01 to May '04) incidences distorted by the dot-com bubble. If they were included, Phase III's mean and median CAGRs (compounded annual growth rate) would be -4.4% and -1.1%, respectively, over 7 incidences and Phase IV's would be 20.3% and 9.2% over 9 incidences. The 2-month Phase II incidence spanning the October '87 crash (-80% CAGR) has also been excluded.

We have been in Phase IV since January 2008 and will remain there until the first rate hike. As noted by BCA, the durations of Phase IV and Phase I are significant because the level of rates (easy or tight) has trumped their direction (lower or higher) when it comes to explaining S&P 500 returns. In fact, all of the stock market's returns in the past 50-plus years were achieved when monetary policy was easy.

Neutral / Equilibrium fed funds level, not a fixed number but a non-dampening/ non-stimulative rate.  Estimated at 3.5 - 5.5% fed funds rate
https://www.frbsf.org/education/publications/doctor-econ/2005/april/neutral-monetary-policy/

Pullbacks have been mild historically

It is common to experience some volatility and initial pullbacks when moving toward the initial rate hike. In looking at the past five rate hike cycles, the average pullback—nearly always having concluded before the actual first hike—was less than 6%, therefore not even qualifying as a "correction," which is -10%. The magnitude of the pullback was directly tied to the magnitude of the back-up in two-year Treasury yields. So keep an eye on those as we approach the initial rate hike.

Dot plot

2/2018 still in Phase 1, easy / hikinh mode

fred.stlouisfed.org/series/FEDFUNDS  2/2018 = 1.42%

Fed Funds Rate

www.bloomberg.com/graphics/fomc-dot-plot/       2/2018 =     2.75%

Equilibrium Level

Ray Dalio Linked in post:
https://www.linkedin.com/pulse/its-all-classic-main-questions-timing-what-next-downturn-ray-dalio/

In the “late-cycle” phase of the short-term debt/business cycle, when 
a) an economy’s demand is increasing at a rate that is faster than the capacity for it to produce is increasing and 
b) the capacity to produce is near its limits, prices of those items that are constrained (like workers and constrained capital goods) go up. 
At that time, profits also rise for those who own the capacities to produce those items that are in short supply. Then the acceleration of demand into capacity constraints and rise in prices and profits causes interest rates to rise and central banks to tighten monetary policy, which causes stock and other asset prices to fall because all assets are priced as the present value of their future cash flows and interest rates are the discount rate used to calculate present values. That is why it is not unusual to see strong economies accompanied by falling stock and other asset prices...

What we do know is that we are in the part of the cycle in which the central banks’ getting monetary policy right is difficult and that this time around the balancing act will be especially difficult (given all the stimulation into capacity constraints and given the long durations of assets and a number of other factors) so that the risks of a recession in the next 18-24 months are rising. While most market players are focusing on the strong 2018, we are focusing more on 2019 and 2020 (which is the next presidential election year). Frankly, it seems to be inappropriate oversight to not be talking about the chances of a recession and what that recession might look like prior to the next election.